Friday, October 01, 2010

AIG Math Follow Up - The Good News And the Bad News

The good news is that there's an answer to my rhetorical question, "So talk to me, people - why shouldn't we be outraged that AIG managed to swindle the Government once again, getting us to convert our senior (preferred) holdings into junior (common) holdings worth roughly $6B less?"  The answer is that the Government isn't $6B worse off in this deal (converting at $45 compared to $39).  I'll explain in a minute. 

{instant tangent:  we can't tell if the gov't is worse off doing the Series E/F/G Pref conversion at all, because we don't know what the stock price would have been if the conversion hadn't been done.  I calculate $27.50 as the breakeven non-conversion scenario price for the government on a mark to market basis for converting to common equity, ignoring seniority of capital structure (or lack thereof, with common equity!) and also ignoring Preferred dividends.  This assumes that the government merely exercised its 80% warrants from the Series C preferred receiving 563MM shares of AIG common.  If the price with no Series E/F/G conversion were above $27.50, the Government is losing money by doing the conversion.  I hesitate to say that the pre-announcement price of around $35 reflects the non-conversion scenario, because I think that expectations of the conversion have seeped into the market over the past several months, driving the stock price higher}

The bad news is that my three questions to Treasury: "Why is the treasury converting senior obligations into junior obligations at a discount?  How does Treasury justify the roughly $45 conversion price?  Why are we giving non-government AIG common shareholders another subsidy?"  still stand, and remain as unanswered (And potentially unanswerable) as ever.  Still, this probably comes down to more of a matter of principles, rather than big bucks - the fact that it's a "discount" - done at a $45 conversion price vs a $39 conversion price means relatively little in the end.  Of course, the alternative didn't have to be a conversion at $39 - it could have been a conversion at a discount to market value, but still, you'll find that the amount left on the table is in the neighborhood of $1B - not trivial, but much smaller than the $6B I cited earlier.

We're going to have to do some math here, but don't be intimidated, it's simple spreadsheet stuff.  Now, the details of the announced conversion imply a market cap of roughly $70B for AIG.  Here's how we get to that:

Current shares outstanding (non gov't):  135MM
Gov't shares issued:  1655MM
Total post conversion shares:  1790MM
Market price:  $39
Implied post conversion market cap:  1790MM x $39  = $69.8B
Implied value of Gov't stake:  1655MM x $39  = $64.5B

In order to compare different dilution (conversion price) scenarios, we need to lock a key assumption - that the value of AIG doesn't change.  Thus, regardless of the conversion price, we assume that the post-conversion market cap of AIG will be $69.8B

From this, we can see that if the conversion price on the Series E/G Preferreds was $39 instead of $45, the numbers change as follows:

Gov't Shares Issued will be 563MM (from the Series C 80% warrants - that doesn't change) +1067MM from the Series E Prefs (41.6B / $39) + 192MM from the Series G Prefs (7.5B / $39)

535MM + 1067MM + 192MM  = 1822MM Gov't shares

add that to the 135MM non Gov't shares outstanding, and we get: 

Total post conversion shares: 1957MM 

Now back into the post conversion market price by using our fixed $69.8B market cap:

$69,800/1957 = $35.66 implied post conversion price. Obviously, there are more shares outstanding, so the price is lower.

Implied Value of Gov't Stake with $39 conversion price:  1822 x $35.66 = $64.972B

So we can see that the value of the Gov't stake would be slightly higher, of course, with a lower conversion price - but nowhere near the $6B number I got in the prior post.

You can make your own spreadsheet for different scenarios - if the conversion price were $20 per share, the Government would be $2.278B better off when compared to the $45 conversion price (for example).

What's the bottom line?  Well, I WAS missing something in the math - in terms of the impact of the conversion price - but the core questions still remain: "Why is the treasury converting senior obligations into junior obligations at a discount?  How does Treasury justify the roughly $45 conversion price?  Why are we giving non-government AIG common shareholders another subsidy?

I wrote in the beginning that this is a matter of principles.  I've been against bailouts and bastardizing of the capital structure since day 1 of this financial meltdown - my views haven't changed, and I don't want AIG or its shareholders bailed out to any extent.  If Treasury's conversion had been done at $39 instead of $45, however, it wouldn't have made a monstrous difference, but it would have looked a lot better optically to people who didn't do the second step math (like me, earlier!). 

As I wrote above, it's impossible to say if the Series E/G conversion itself was a terrible idea - it depends on what the non-conversion-scenario  (the one where we just exercised our 80% warrants, but didn't convert the Series E/G Prefs)  AIG price was - which we don't know, because we don't have a vacuum and a time machine.


thanks to JCK of Alea Blog for putting me on the right track with his comment on Felix Salmon's blog post.

I understand your point, what you seem to miss is that it makes no sense to maximize the conversion ratio on the preferreds (E and F) when you own de facto 80% of the equity, unless you want to shoot yourself in the foot, since the higher the conversion ratio the less valuable the equity."


Unknown said...

I'm not worried about the money.

Doesn't common stock vote and not preferred stock? I'm more comfortable with the government owning non-voting shares.

You want to be the CEO? Better donate to the right political party! You want to stay CEO, better find some congress critters brother a job as a manager of a section.

I would rather the Government lose money than encourage the corruption in our government.

Anonymous said...

i'd imagine that they need to do the conversion to attract private capital -- ie to float a public offering. pre-conversion, it's tough to get that capital given that common stock would be junior to a huge senior obligation to the government.

as for whether the taxpayers are getting a good deal or not out of this, i'd ask a couple other questions. as i understand it current stockholders are getting 8% of the company and the government 92%. so the government could only be doing about 9% = 100%/92%-1 better than it is doing.

so first question is, what's the big deal then? second question is whether the government has to worry about the legal basis for its actions.

there was no declared bankruptcy so there has been no event that would wipe out the common stockholder, so legally there has been no event that would zero out the value of common stock. since the government is orchestrating this, they are bound by the "takings" clause of the constitution -- no expropriation of public property without restitution -- and as such they have to consider legal challenges to any plan. essentially they have to show that stockholders as of pre-takeover were not screwed. now you may believe, and i may believe, that AIG shareholders at that time aren't due anything, but is this something that you can prove in a court of law?

Kid Dynamite said...

Anon - 8% of $70B is not trivial.

Can one prove in a court of law that AIG shareholders are not due anything? Hmmm. I'm not a lawyer, but I'd guess that wouldn't be the hardest case in the history of mankind to prove... (see: outstanding gov't assistance provided)

Anonymous said...

same anon here

true, 8% of 70B is not trivial. but if stockholders weren't wiped out, then they were down > 95%.

nope, government seizure and assistance are not evidence that AIG, once liquidated, would have zero equity value. all that is certain is that they didn't have sufficient liquidity -- and would have defaulted on some debt -- on sept 16 2008. that proves precisely nothing about equity value on that date.

even if you could have proved zero equity value on that date, that's beside the point. you would need to prove zero equity value TODAY, or at least zero equity value before conversion. remember that the government did not force the company into bankruptcy, and so shareholders never lost their rights to residual value. the fact that the residual value might have been < 0 at some point along the way is completely irrelevant. the fact that they received government assistance is not relevant either. the

Kid Dynamite said...

anon - I hear you.